Tuesday, October 29, 2013

Don Boudreaux has been arguing that monopsony cannot be an important factor in unskilled labor markets because if it were, there would be profit opportunities from starting a new business that employs unskilled labor. If there is no monopsony in those markets, then a minimum wage would tend to reduce the employment of unskilled labor. Since destroying the jobs of unskilled workers is a bad thing, Boudreaux considers this a good argument against the minimum wage.

I don't favor a minimum wage and I think Boudreaux's argument has an element of truth. However, when reading it, I began to think about monopolistic competition. In long run equilibrium, there is no profit and no incentive for further entry. Price is equal to average cost. But price still exceeds marginal cost. The downward sloping demand curve for each firm results in a marginal revenue less than price. The profit maximum, which happens to be a break even point, is where marginal revenue equals marginal cost. Price and average cost are both greater than marginal cost. With a U-shaped long run cost curve, that makes output less than the level that would minimize long run average costs. Each firm has "excess capacity."

Can the same kind of reasoning apply to monopsony? The firms face an upward sloping supply of labor function. If they pay all of their workers more, then more workers will be willing to work for the firm. This makes the marginal cost of labor greater than the wage. The increase in wages that must be paid to the additional worker is an added cost, but the added wages paid to all of those workers who would have being willing to work at the existing wage is an added cost as well.

The firm maximizes profit where the marginal revenue product of labor is equal to the marginal cost of labor. The marginal cost of labor is greater than the wage. The marginal revenue product of labor is also greater than the wage. This implies that hiring another worker at the existing wage would add to profit. But paying more to all the workers so that another worker will come will reduce profit.

This might suggest that entering the industry would be profitable. However, profits depend on revenue and total cost, or equivalently, price and average cost. Does the fact that the wage is less than the marginal cost of labor and the marginal revenue product of labor, have the implication that average cost is less than price? The wage is something that impacts average cost.

Still, consider the following simple scenario. Workers walk to their jobs. The firms are distributed across the landscape. At a low wage, only the workers closest to a firm will choose to work there. At a higher wage, workers a bit further off will work at the firm. Each firm faces an upward sloping supply curve for labor due to geography. This results in monopsony.

Suppose all the firms are profitable. Entry occurs. The firms are bit more crowded across the landscape. The typical worker is closer to a firm. Still, each firm faces an upward sloping supply curve, and maximizes profit where the marginal revenue product of labor equals the marginal cost of labor. However, entry continues until the price is equal to average cost and there are no more profits.

As with the simple monopolistic competition model, there are "too many" firms. Here, each firm is paying too little rather than charging too much. The offsetting benefit of monopolistic competition, the added variety of products, is here represented by having more households having more convenient places of employment--closer to home. The same would be possible with monopolistic competition, more firms would make it possible for more households to have shops closer to home.

A minimum wage, then, would result in fewer firms, each operating at a larger, more efficient scale, hiring more workers and paying them more. Shifting to this new equilibrium would involve transitional losses for all firms and failure for some. The stronger firms survive, face less competition, and are able to expand to a more efficient scale. Some of the workers have to travel further to work because there are fewer places of employment.

Anyway, it seems possible.

As I have explained before, there is a range of minimum wages that would expand employment in a monopsonistic firm. A minimum wage at the going monopsony wage leaves a shortage. Actual employment is supply constrained. As the minimum wage rises, quantity of labor supplied rises, and firms hire the extra workers. At some point a maximum employment is reached and there is no shortage of labor. The minimum wage equals the marginal revenue product of labor. Increasing the minimum wage above that level results in the firm reducing its desired hires. Now employment is demand constrained. At some point employment matches what would have been provided by the monopsonist, though at a lower wage. Of course, there is a much larger range, going to infinitely high, that would reduce employment from what the wage-setting, profit maximizing monopsonist would choose.

Having the political system set a different minimum wage for each firm is unrealistic. Setting a single minimum wage for all firms will almost certainly result in a minimum wage that raises employment in some monopsonistic firms and lowers it in others. And, of course, those firms where monopsony is irrelevant, or even appears irrelevant to the employers, would have a straightforward negative employment effect due to the minimum wage.

Interestingly, a monopsonistic labor market is in shortage. The marginal revenue product of labor is greater than the wage. This creates a motivation for firms to keep their employees happy. When employees leave, employers are anxious to replace them.

Further, if the supply of labor increases, there is an immediate incentive to take on more workers. They will add to profit!

Of course, the firms will have an incentive to lower wages in response to an increase in the supply of labor. Now there is an interesting empirical test. Do firms that receive a resume respond with a new compensation schedule of lower pay for everyone?

If the demand for labor is rising faster than the supply, the equilibrium monoponistic wage will be rising too. And so, a more rapid increase in the supply of labor would just result in slower wage increases. Which is, of course, exactly what would be observed in a competitive labor market.

That is the first test I would use when considering a minimum wage. Is the market in question in shortage? Are all those workers who want to work employed? Do those workers not employed say that the problem is excessively low wages and they would rather stay home? If a labor market is demand constrained, with unemployed workers desiring a job at the going wage, monopsony is not likely to be a problem.

Monday, October 28, 2013

On the bright side she again advocates nominal GDP level targeting, both as a solution for the current crisis and a long term regime.

She also explains how the shift in monetary policy in the Great Depression spurred the recovery of 1933. In fact, it seemed she just covered ground that Scott Sumner covered years ago.

Less happily, she advocates greater bank regulation. On the other hand, increased capital requirements are one of the least bad approaches--at least if banks can "use" their capital cushions when losses develop.

Worse, she wants central banks to try to pop asset bubbles. My view is that the monetary authority should focus entirely on expected nominal GDP. Allowing/causing expected nominal GDP to fall in order to cause asset prices to fall towards what the monetary authority thinks is the proper mistake is malpractice.

There have been claims that a world financial crisis is possible if the U.S. government has any delay paying interest or principle on bonds. While I have my doubts about that, there is no reason to expect a world financial crisis if the government fails to pay for goods it already has received much less fail to spend money on what Congress has appropriated. The claim that failure to increase the debt limit creates a threat of world financial crisis is again, dishonest. What is really happening is that the Obama administration is threatening to cause a world financial crisis by failing to pay interest and principle on the national debt and instead spend that money on other things.

Now, suppose the Obama Administration carries out this threat. The debt limit is reached and the treasury just spends appropriated funds as it receives requests for funds. When they run out of cash, they just stop making payments. And if some interest and principle claim show up during that period, then they are not paid.

Some claim that the interest rates the government would have to pay would rise. This seems plausible enough. But the next step in the argument is wrong. The notion that higher interest rates would slow the economy and lead to recession is false.

By purchasing government bonds that the government is selling, the Federal Reserve can keep interest rates on both government bonds and the economy low. As the government sells new bonds as old bonds are repaid (in an apparent hit or miss fashion,) the yield on the bonds can stay low. The interest rate on these bonds will only need to rise to head off inflation. And while that is a very possible scenario, the problem will not be anything like what happens when the Fed increases interest rates by restricting growth in the quantity of money.

Further, it is a mistake to assume that other borrowers would have to pay higher interest rates. Usually, U.S. government bonds are assumed to be risk free. Other sorts of bonds have higher interest rates because of default risk. If the "risk free" interest rate on government bonds should rise, then all of the other interest rates will rise with them, with the "spreads" representing different levels of risk assumed to be constant. But when the government bonds have higher interest rates because of higher default risk, then this is no longer the correct analysis. What happens instead is that some of those who were holding government bonds as a "perfectly" safe asset will respond to the greater risk on them by selling them and purchasing other securities that were slightly more risky. The interest rates on those securities will fall, making it easier, not harder, or the firms issuing those securities to borrow.

Of course, there is another effect. Those holding short and safe assets like government bonds, would likely respond to the risk of delayed payment by holding money instead. If the quantity of money fails to expand enough, the resulting liquidity squeeze will tend to raise all interest rates. But then, that is why the Federal Reserve would need to expand the quantity of money in such a situation. It can and should supply the extra money that people would want to hold, and so avoid a liquidity crunch.

Tuesday, October 15, 2013

The Administration claims that they are too incompetent to prioritize interest and principle on the national debt. While that is likely a lie, and they are simply threatening to default on U.S. government bonds to coerce fiscal conservatives to let them continue to borrow and spend, there is an alternative. If the Federal Reserve buys the maturing debt, then those holding the debt are paid off. The Fed is then left holding debt whose payment is delayed until the Treasury obtains enough cash to pay it off using its "system," presumably first come first serve.

Since the amount of money appropriated by Congress exceeds current revenues by nearly $600 billion, the government would have to spend less than what has been appropriated--about 16 percent less.

President Obama and his supporters in Congress are using the term "default" to mean failure to obtain enough money to spend everything appropriated by Congress. That is a dishonest.

If the debt limit is reached, then as government bonds come due and the principle paid off, the national debt will fall below the limit. The government can sell new bonds to raise the funds needed to pay off the next set of bonds that come due.

However, the interest that is paid on these bonds is a current expenditure of the government. The net interest is about $250 billion per year, which is approximately 8% of the approximately $3 trillion of government revenues. The government collects way more current revenue than is needed to cover interest payments.

So, the government can pay interest and principle on the national debt with no problem. The cuts in all other government spending would be slightly deeper, a bit more than 18 percent, rather than 16 percent.

Certainly such deep cuts in government spending are no joke. It is approximately 4% of the total economy. Of course, that does leave 96 percent of the economy. And what is sacrificed is the value of the government goods and services that aren't provided. Normally, I would anticipate that the production of private goods would only gradually expand as resources are freed, and further, if the reduction in government spending is temporary, that increase in private production would never occur. However, what if the government reduces transfer payments? Also, I believe the current production of private goods is well below capacity, so there is room for a rapid increase in the production of private goods and services.

What does President Obama and his apologists say to arguments that default isn't necessary? Mostly, they just repeat their dishonest talking point. Failure to spend whatever Congress appropriated is defined as "default."

But there have been some arguments. Supposedly the Treasury is not up to the job of making sure that interest and principle are paid on the national debt. It is just too complicated. If that is really true, the Secretary of the Treasury should be fired and President Obama should resign in shame for incompetence. Just because the Treasury has considered its job to be coming up with the money to cover all appropriated expenditures in the past, does not mean that they shouldn't be prepared to face a hard budget constraint--limit spending to what is available rather than assume an unlimited ability to borrow.

And, of course, the Obama Administration has opposed legislation officially making debt and interest payments a priority. I heard an administration apologist on the radio already making the argument that interest and principle shouldn't be a priority. Which is more important, paying the Chinese (interest and principle on the bonds,) or Grandma (social security.) Cutting social security checks and failing to pay interest and principle on bonds when due is a choice to default. Of course, Social Security payments are running about $700 billion, so $3 trillion in revenue would be enough to cover those payments as well.

The bottom line is that if the government fails to pay principle and interest on the national debt, it will be because President Obama decided that is what he wants to do. It is a policy determination that other sorts of government spending, say on Obamacare or food stamps, is more important.

Some claim that it would still be a default if the government didn't pay all of its bills. Well, to the degree that the government has already committed to a vendor to purchase a good or service, and especially if it has already received delivery, it does owe the money. Once a payroll is due, the work has already been done. That is a debt of sorts. Of course, when you are running out of money, you need to stop ordering new products. And it is also when you start implementing furloughs and layoffs. You stop making commitments to spend money you won't have.

However, appropriations by Congress aren't the same thing as goods and services already purchased and outstanding bills. I heard on the radio someone argue that if you pay the mortgage and don't pay your utilities, your credit rating will still suffer.

Admittedly, it would be difficult to do without electricity. But consider the following scenario. The family made a budget for the year. They plan to spend all of their income, and use their home equity line of credit to go into debt. They are careful planners and decide up front to start going to a healthier restaurant once a week rather than the fast food restaurant they had been patronizing. And they finally get cable TV, with all the bells and whistles.

In the middle of the year, the line of credit is cut off. They stop going out to eat at the health food restaurant and return to fast food. Is that a default? No, not in anyway. But President Obama is defining government default to be any cut in planned spending. Suppose they cancel their cable subscription. Is that a default? No.

But suppose they just don't pay the last cable bill because they need to money to make their mortgage payment, including the payment on the home equity line. Is that a default? Yes. And it would hurt their credit rating.

Now, what does the bank collecting their mortgage think about that? While it would be better for the family to have paid their last cable bill and then cut off the service, maybe skipping the fast food restaurant meal and staying home for dinner, the banker would actually like that they treat the mortgage as a priority.

In my view, failure to raise the money appropriated by Congress that has not actually been spent is not a problem at all. It is like economizing by purchasing less expensive food at the grocery story and spending less on recreation. It would be a clear positive from the point of view of bond holders. This is especially relative to the status quo where President Obama is threating not to pay them even when there is 10 times more money than what is needed to pay them because he wants to spend on his favorite new programs.

Now, if the Treasury were to stiff vendors who had already delivered goods of some types, say jet aircraft and used the savings to maintain spending on other goods where no commitment had been made, that would be bad. It is like continuing to eat at the health food restaurant while failing to pay the cable bill received for last month's services. A sign of irresponsibility.

However, it is still true that if the Treasury won't pay for the jet aircraft already produced and delivered, and the reason is that they needed that money to pay interest and principle on the national debt, that would help reassure those holding the debt. They have made the debt a priority.

Wednesday, October 9, 2013

Jeffrey Hummel has a good article about the relationship between money and interest rates. I think that there is a bit too much emphasis on the thought experiment of a permanent change in the growth rate of the quantity of money. I have become more and more focused on a situation where the quantity of money is endogenous because the monetary regime targets something else. Sometimes I focus on the growth path of nominal GDP. That is because I am very interested in the characteristics of such a regime. I also think about a target for the inflation rate, because that appears to be a key characteristic of really existing monetary regimes.

Given these other targets, what happens when there is a temporary increase (or decrease) in the quantity of money? No longer are we working out the equilibration process of a permanent change in the growth path of the quantity of money. What happens when the quantity of money rises, and those holding the money expect the increase to be reversed because it is inconsistent with the nominal anchor?

Hummel's argument is very consistent with the Market Monetarist notion that permanent changes in the quantity of money impact spending on output. Much of the argument that changes in money growth do not impact interest rates very much depends on a prompt impact on spending on output and the consequent change in inflation and real output growth. It is much less consistent with a simplistic New Keynesian approach where monetary policy is a lower interest rate, which results in higher real consumption and real output, and so an output gap that leads to higher inflation.

It is wrongheaded to combine these two views and say that an expansionary monetary policy will not lower interest rates, and because interest rates don't fall, real expenditure and real output won't rise and so inflation won't rise, and therefore the sum of real output and inflation, nominal GDP growth, will not rise. There is a contradiction there. It is the more rapid growth in real output and inflation that eventually reverses any decrease in interest rates, and in the extreme, leave interest rates unchanged despite more rapid money growth.

But if the nominal anchor is such that an increase in the quantity of money must be temporary, and so there will be little or no increase in spending on output and so little or no inflation or additional real growth, then what does the unusually high quantity of money imply for interest rates?

Miles Kimball has another post on Wallace Neutrality, which is the theoretical argument proving that quantitative easing is not effective. Kimball explains that the math shows that open market operations can have no effect, given Wallace's assumptions. The assumptions, however, are highly unrealistic.

Kimball points out that the Wallace result requires assumptions of perfect knowledge of the fundamental values of whatever the Fed is purchasing as well as an ability to borrow unlimited funds at the zero-risk interest rate and no concerns regarding risk by the arbitrageurs. None of that is even close to reality. Following the convention in financial economics, failure to meet these requirements are "frictions." To me, frictions sound like small things that slightly gum things up. However, might it be that assumptions behind an absence of these "frictions" are so far removed from reality that it tells us approximately nothing about the real world?

What I found more interesting was the "intuitive" explanations that depended on the Fed eventually reversing its open market operations. For example, if there is perfect knowledge of the future equilibrium price of gold, and the Fed creates large amounts of money and buys gold now, this will not impact the price of gold at all. That is because the Fed will sell all of that gold and reabsorb all of the money in the future, and the price will be back where it was supposed to be. What happens in the meantime? "Arbitrage." Kimball didn't explain the process, but I guess someone will borrow gold and sell it short to the central bank. That no one is really in a position to sell gold short in unlimited quantities is just a "friction" in the world of Wallace neutrality.

But one hardly needs "Wallace Neutrality" to understand that temporary changes in the quantity of money have little effect on anything. Krugman's unpublished paper on the issue is probably the best known argument, though we Market Monetarists know that Sumner explained it before Krugman. It has nothing to do with open market operations. If the quantity of money doubles this year, with the new money appearing out of thin air, then we would expect that the price level would roughly double. But suppose all of that money will be sucked away one year later. Then that would cause the price level to fall back to its initial level. This is a temporary increase in the quantity of money. Who would buy a house at twice its current value when it is expected to fall in half in a year or less? What is going to happen then? People will largely hold the excess money balances during the period when they are extra high. The demand for money temporarily rises and velocity temporarily falls enough to offset the temporary increase in the quantity of money.

What is the likely result? At first pass, the price level will rise immediately when the quantity of money increases, but only enough so that as it returns to its initial level, the rate of deflation will equal the real interest rate. If the price level rises more, then the deflation will make holding money more attractive than holding other assets. This motivates the increase in the demand to hold money and the reduction in velocity sufficient to prevent any further temporary increase in the price level.

However, why doesn't Wallace neutrality apply when short and safe interest rates are above the zero nominal bound? Of course, in new Keynesian models, there is no process by which open market operations cause changes in the policy interest rate. The policy interest rate is taken as exogenous. The interest rate is adjusted, and consumption is shifted between now and the future. The future level of consumption is fixed at the full employment level, and so a lower interest rate increases current consumption and a higher interest rate lowers current consumption. The Wallace Neutrality result doesn't come into play because there are no open market operations going on at all. New Keynesian economics is reasoning from a price change. As Sumner constantly points out, that is not sound economics.

Still, whether Wallace neutrality only works when at least one interest rate hits zero, or supposedly keeps the central bank from ever impacting any interest rate (see Kling here,) it still remains true that quantitative easing, in even massive quantities, will have very little impact if the central bank promises to reverse it. Suppose the central bank undertook massive quantitative easing but committed to keeping spending on output on its existing growth path. Would quantitative easing have any effect? And what would be the point of quantitative easing if not to increase spending on output?

Now, suppose that the central bank would be happy for spending on output to rise, but only if there is no inflation. In other words, the central bank wants to reduce the output gap with no increase in inflation. That would have an impact only to the degree this was believed possible. But those who expect that closing the output gap will resulted in higher inflation (rather than reduced disinflation,) then they would expect that increase in the quantity of money would be temporary. And so they would be willing to accumulate more money, implying reduced velocity and so little impact on current expenditures.

It is considerations like these that make Market Monetarists insist that if spending on output should increase, then the central bank needs to target an increase in spending on output. Quantitative easing until labor markets improve unless inflation gets too high is just not very effective.

Now, if spending on output is targeted, then the proper amount of quantitative easing is whatever it takes. But the "whatever it takes" is pointless when a central bank creates expectations that it will prevent any increase in spending on output. Unfortunately, committing to prevent inflation has that effect.

Sunday, October 6, 2013

Arnold Kling has a post about whether the money multiplier exists. Scott Sumner commented. Sumner points that that the money multiplier exists, because it is simply the ratio of some measure of the quantity of money and the monetary base. Sumner then presents some simple algebra, so that the money multiplier equals (1+c)/(c+r), where c is the ratio of currency to deposits and r is the ratio of reserves to deposits. He states that these ratios depend on utility maximization.

Sumner's claim is true enough, though I think most economists studying banking would use something like maximizing expected profit to relate the demand for reserves by banks to the deposits they supply. Further, I don't think a the ratio of reserves to deposits is the best framing for the banks' relationship, though of course a ratio exists between the profit maximizing quantity of deposits and the profit maximizing demand for reserves. Neither do I think that most people optimize a ratio between currency and checkable deposits. I know I don't. I do think that both the demand for currency and deposits are positively related to spending on output.

The paper Kling cites appears to focus more on reserve requirements and emphasizes that a substantial portion of M2 has no reserve requirement. Their approach assumes that the central bank offsets currency drains, making the quantity of currency endogenous, and instead controls the quantity of reserves. The reserve requirement then creates a fixed ratio between reserves and bank deposits. To read Kling's discussion, the purpose of controlling deposits would be to control bank lending. And so, showing that there is no close relationship between bank lending and reserves proves that there is no money multiplier. A dollar of additional reserves does not create a more than proportional increase in bank loans.

Kling goes on to argue that the Fed supposedly is impacting the economy by purchasing bonds, which lowers long term interest rates. He argues that since the Fed's purchases or sales of bonds are so small compared to the world supply and demand for bonds, it can have no more than a minimal impact on world long term interest rates, and so has no impact on anything. While I think there is an element of truth in Kling's argument, a central bank in a small economy with completely open capital markets would impact spending on output and inflation through changes in the exchange rate. If the central bank is pegging the exchange rate, then sure enough, it has no effect on much of anything else.

Of course, neither traditional monetarists nor market monetarists were much interested in what, if any, effect central banks might have on long term interest rates or the quantity of bank loans. While Sumner has long given up on worrying about any measure of the quantity of money broader than the base, most market monetarists focus on the quantity of the medium of exchange relative to the demand to hold it. The medium of exchange is made up of a variety of financial instruments, and the day in which most of them were issued by commercial banks is long past.

Kling expressed surprise that retail mutual money market funds are included in M2. He says that he thought that M2 was M2. What would that be? Currency, checkable deposits, and savings accounts? I am not really sure. My concern with M2 was primarily the inclusion of small certificates of deposits. What sense does that make? In world where other nominal magnitudes are growing, can a $100,000 limit make any sense? I had no trouble with the addition of retail money market funds. As they came into existence, adding them to the measure of the quantity of money made perfect sense. But how can a $50,000 cut off make sense? Why not all of them?

Fortunately, MZM has existed for years, and it supposedly included all financial instruments with a zero term to maturity. No certificates of deposit and all money market mutual funds. Unfortunately, my personal experience always left me a bit troubled. My savings account balance is subject to restrictions on withdrawals. More important, I don't count it as part of my ready money balances. Further, when I did have a money market mutual fund account, the restrictions on using it were more burdensome than a saving account. Of course, I am just a small retail customer.

Years ago, Eurodollar accounts and repurchase agreements were included in M3, but both overnight and term instruments were included. And then, M3 was no longer measured. Overnight repurchase agreements, which have served as a monetary instrument for years, was never included in M2, but was not added to MZM. As the shadow banking system developed, repurchase agreements became a progressively larger portion of the quantity of money. Of course, those held by money market mutual funds were included in MZM indirectly, but any directly held by corporate treasurers or financial institutions were an unmeasured portion of the quantity of money, a portion whose quantity collapsed in 2008. The Divisia measures of the quantity of money did capture that effect. The M3 and M4 Divisia measures collapsed during that period.

These other monetary instruments have become more and more entwined with checkable deposits. The development of sweep accounts has allowed liquid funds to be held, or at least reported as being held, in a money market account, a money market mutual fund or as a repurchase agreement, while always being available to cover checks, or electronic payments. The existence of sweep accounts is at least partly motivated on the prohibition of interest payments on demand deposits, or in other words, for the transactions accounts held by business customers. They can earn interest by having excess funds swept into interest bearing accounts.

However, there is another impact of sweep accounts. Banks sweep funds out of transactions accounts before they report the quantity to the Fed, and it is that reported quantity that determines the amount of required reserves. By convincing customers to use sweep accounts, banks can reduce their required reserves to something below what they find it profitable to hold. Since vault cash counts as reserves, and at least some banks need vault cash to meet the needs of their retail customers, the banks' desired reserve ratio remains positive. And there is little reason to believe that the banks required reserves were much different.

Of course, with the payment of interest on reserves, and the very low interest rates on other money market instruments, there is little reason to use sweep accounts to reduce required reserves. The level of reserves banks find it profitable to hold is much larger than the requirements. The reserve requirements are ineffective under current conditions.

Given what amount to scams aimed at getting around unnecessary and undesirable regulation, is there any surprise that reserves have no fixed relationship to incomplete measures of the quantity of money?

Free banking theorists, like George Selgin, have developed the theory of the precautionary demand for reserves. It doesn't have a fixed relationship to the quantity of deposits. Selgin argues that it depends on spending on output. The argument runs through the volume of gross payments and so the variance of net clearing balances. In particular, if the demand to hold bank deposits rise, the demand for reserves falls, leading to a lower equilibrium reserve ratio. Selgin emphasizes the argument that the reduced reserve ratio causes an increase in the quantity of deposits, accommodating the increased demand to hold deposits.

One key element of the status quo that is very different from the regimes Selgin describes is that banks cannot issue hand-to-hand currency. Holding reserves in the form of vault cash is necessary to meet customers' routine demands for hand-to-hand currency.

Further, consider the role of inter-day overdrafts. Do banks have to hold sufficient reserve balances to cover all claims, or can they maintain negative balances at the central bank/clearinghouse as long as they are covered later? That rule will influence the demand for reserves.

More importantly, if there is a central bank that is targeting the interbank clearing rate, then the incentive to hold reserve balances is greatly reduced. One reason to hold reserve balances is that if there is a shortage of reserves in the system, excess reserves can be lent at higher interest. And, of course, banks with a need for reserves in such a scenario avoid high borrowing costs. They have the reserves they need.

My answer to these issues is not to develop some regulatory scheme that keeps the true measure of the quantity of money proportional to base money. The tie between base money and the broader monetary aggregates is redeemability. Those other instruments are redeemable for base money. While there is no guarantee for any kind of proportional relationship between the aggregates, control over the base is sufficient to prevent an excess supply of the other aggregates. And what about excess demand? In the end, base money is part of the quantity of money, and by expanding it enough, decreases in the quantity of other monetary instruments can be offset.

Like Sumner, I think the answer is to a money multiplier that can shift is to adjust the quantity of base money according to the demand to hold it. Unfortunately, that begs the question of what is the nominal anchor. If the quantity of base money adjusts to the demand to hold it, it cannot serve as nominal anchor. In my view, a growth path for spending on output, in particular, nominal GDP, is the least bad approach.

With respect to the interest paid on reserves, there seems to be a general failure to appreciate that paying an above-market rate on reserves changes the sign of the effect of a portfolio expansion. Under the traditional policy of paying well below market rates on reserves, banks treated excess reserves as hot potatoes. Every economic principles book describes how, when banks collectively hold excess reserves, the banks expand the economy by lending them out. The process stops only when the demand for deposits rises to the point
that the excess reserves become required reserves and banks are in equilibrium. That process remains at the heart of our explanation of the primary channel of expansionary monetary policy.

So far so good.

With an interest rate on reserves above the market rate, the process operates in the opposite direction: Banks prefer to hold reserves over other assets, risk adjusted. They protect their reserve holdings rather than trying to foist them on other banks. An expansion of reserves contracts the economy.

I don't really understand this. An expansion of reserves will contract the economy? I think the higher interest rate on reserves contracts the economy by raising the demand for base money. Expanding the quantity of reserves helps satisfy the additional demand.

What could Hall have in mind?

Is this only true when the Fed purchases T-bills? If T-bills provide more monetary services than reserves for some purposes, then having the Fed buy them could contract the quantity of money services. And if T-bills have yields below those of reserves, maybe they do provide more monetary services than reserves. That is at least one reason why they might have such low yields.

But suppose the Fed purchases securities with yields greater than those on reserves? For example, long term government bonds or mortgage backed securities. How could that be contractionary?

Anyway, if it is really true that an expansion of reserves contracts the economy when interest rates on reserves are above market rates, then quantitative easing is counter-productive.

Regardless of whether expanding reserves is contractionary, I am all for Hall's solution:

The Fed could halt this drag on the economy by cutting the rate paid on reserves to zero or perhaps -25 basis points.

And I agree with this response to the supposed reason the Fed pays interest on reserves at this time:

The only excuse for not cutting the reserve rate is the belief that short rates would fall and money-market funds would go out of business. This amounts to an accusation that the funds are not smart enough to figure out how to charge their customers for their services. Traditionally, funds imposed charges ranging from 4 to 50 basis points, in the form of deductions from interest paid. A money-market fund using a floating net asset value can simply impose a modest fee, as do conventional stock and bond funds. The SEC may accelerate this move by requiring all money funds to use floating NAVs.